We review a few of our recent opinions for context before getting to the main point of this post:
Is the U.S. stock market overvalued?
Absolutely. In “Bubble or Not, U.S. Stocks Are Priced to Deliver Dismal Long-Term Returns,” we argued that stocks are priced to barely outpace inflation, at best, and more likely to deliver negative real returns over the next 10 years.
Is the market due for an extended correction or consolidation?
Probably. Some of the annual outlooks published recently brought back memories of January 2007. The trendy theme at that time was the idea that stocks would float along on a sea of unlimited global liquidity. Bulls seemed to feed off each other and make ever more extreme predictions, not recognizing that “global liquidity” was another way of describing history’s largest-ever credit bubble. Fast forward to late 2013/early 2014, and bulls were again upgrading their outlooks just as financial excesses were becoming impossible to ignore. It stands to reason that recent volatility may have gotten their attention, especially while the Fed’s QE boost is gradually removed with two tapers done and seven to go (assuming no change in amounts).
It’s also worth noting that returns in the month of January tend to persist. As we discussed here, negative January performance suggests better than 50% odds of further consolidation.
Is the current emerging market crisis a game changer for U.S. stocks?
Unless this is the year that China’s credit markets collapse, our answer is “not so much.” There are a handful of developments that could trigger a full bear in the U.S., but these don’t include events in developing countries outside China. That would be highly unusual, as we’ll show below by looking at six emerging market crises that occurred during bull markets.
Here are the crises, identified by the dates of the events that launched each one into broad public view:
- August 13, 1982. Mexico’s finance minister announces he can no longer meet the country’s loan obligations. Most Latin American countries follow Mexico’s lead and restructure their commitments to U.S. banks in 1982/83.
- February 20, 1987. Brazil announces an interest payment suspension, leading to another series of Latin American loan restructurings in 1987/88.
- December 20, 1994. Mexico devalues the Peso by adjusting its targeted band, and then abandons the band altogether two days later. Market turmoil forces Mexico into a U.S.-led debt bailout in early 1995.
- July 2, 1997. Only two days after ruling out a currency devaluation, Thailand gives up its defense of the baht, triggering sharp devaluations throughout East Asia and a painful regional recession (the “Asian Financial Crisis”).
- August 17, 1998. In reaction to a worsening recession and deteriorating public finances, Russia defaults on its sovereign debt and devalues the ruble.
- January 14, 2011. Tunisia’s president succumbs to public protests and flees to Saudi Arabia as demonstrations and bloodshed sweep the Middle East (the “Arab Spring”). Governments in Egypt and Yemen fall in February.
For each of these events, we looked at S&P 500 (SPY) performance in the prior two months and subsequent six months:
Here are the key results:
- Stocks traded partly higher and partly sideways through Brazil’s 1987 bond default, the 1997 Asian Financial Crisis and the Arab Spring of 2011. None of these episodes included a correction of more than 10%.
- Stocks rallied strongly after each of the crises triggered by Mexico (in 1982 and 1994). Curiously, the long 1980-82 bear market reached its trough exactly one day before Mexico’s August 1982 plea for help.
- The S&P 500 peaked one month before the August 1998 Russian bond default and then fell 19% to a trough two weeks after the default. Following another six weeks of consolidation that was surely extended by September 1998’s LTCM crisis, stocks rebounded strongly.
The chart suggests that emerging market stability is far from the most important factor for U.S. stocks. The present crisis is likely to create more market volatility, but stocks were due for a period of consolidation with or without Turkey’s corruption scandal, Argentina’s reserve drain, Thailand’s violent protests and so on. As shown above, these types of events don’t make the difference between bull and bear markets on Wall Street.
What could make us wrong?
The flip side to our conclusion is that the present crisis is more diverse than earlier crises and includes relatively large countries in all parts of the world. Consider that the so-called “fragile five” developing countries – Brazil, India, Indonesia, Turkey and South Africa – account for over 14% of global GDP. By comparison, the five countries most affected by the 1997 Asian Financial Crisis – Thailand, Philippines, Indonesia, South Korea and Malaysia – totaled only 7% of global GDP. The five largest countries in the 1980s Latin American crises also amounted to 7% of global GDP. The other three crises barely registered at all from a GDP perspective: Russia and Mexico were each 2% of global GDP before their respective 1990s crises, while the Arab countries whose governments fell in 2011 were an even smaller portion of the global economy.
In other words, our chart could be misleading if the present crisis develops into a larger emerging market collapse than we’ve seen in the past. It’s worth watching for that reason, but we’re not yet convinced. If the U.S. bull is ended by global developments, these are more likely to originate in the larger economies of China, Japan or Western Europe.